Analysis, Pages 66 (16416 words)
The concept of risk is intuitively understood by investors. In general, it refers to the possibility of incurring a loss in a financial transaction. But risk involves much more than that. The word ‘risk’ has a definite financial meaning. The possibility of variation of the actual return from the expected return is termed risk. Corporate securities and government securities constitute important investment avenues for investors. These are traded in the securities market.
The securities market is one of the most important sectors in the financial system of our country.
And also contributes much for the economic development. So securities market act as a glittering avenue for potential investors. Investment in securities market also involves risk. The elements of risk may be broadly classified into two groups. The first group comprises factors that are external to a company and affect a large number of securities simultaneously. These are mostly uncontrollable in nature.
The second group includes those factors which are internal to companies and affect only those particular companies.
These are controllable to a great extent. The risk produced by the first group of factors is known as systematic risk, and that produced by second group is known as unsystematic risk. The systematic risk of a security can be measured by relating that security’s variability with the variability in the stock market index. A higher variability would indicate higher systematic risk and vice versa. The systematic risk of a security is measured by a statistical measure called Beta.
But dealing with the beta, there is a problem of reliability.
That is, to what extent the calculated value of beta is reliable. This study deals with the beta estimation practice followed by Indian stock markets, with special reference to Bombay Stock Exchange. Study also looks in to the reliability of beta, of selected 30 companies from BSE. And test whether there is any reliability biasness.
CAPITAL MARKET – AN OVERVIEW
The securities market is one of the most vibrant sectors in the financial system of our country, making an important contribution to economic development.
India had a long and indigenous tradition of savings and entrepreneurship. Even when India was under foreign rule we were always quick to adopt and develop the most modern ways to channel savings into profitable business venture. No wonder, we set up the first stock exchange in Asia. Financial Markets, across the globe, are undergoing profound, exceptional and fast-paced changes. Technology has revolutionalised the processes and the security markets have been operating. The Indian securities market is in transition. There have been revolutionary changes over a period of time.
In fact, on almost all the operational and systematic risk management parameters, settlement system, disclosures, accounting standards, the Indian securities market is fit enough to compete with the global standards. Indeed, on a few paradigms, it is ahead of the global benchmarks. The origin of the Indian securities market may be traced back to 1875, when 22 enterprising brokers under a Banyan tree established the Bombay Stock Exchange (BSE). Over the last 125 years, the Indian securities market has evolved continuously to become one of the most dynamic, modern and efficient securities markets in Asia.
Today, Indian markets conform to international standards both in terms of structure and in terms of operating efficiency. Today India has two national exchanges, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Each has fully electronic trading platforms with around 9400 participating broking outfits. Foreign brokers account for 29 of these. There are some 9600 companies listed on the respective exchanges with a combined market capitalisation near $125. 5 bn. Any market that has experienced this sort of growth has an equally substantial demand for highly efficient settlement procedures. In India 99. % of the trades, according to National Securities Depository, are settled in dematerialized form. With the sweeping economic changes witnessed globally towards more market oriented economies, the government of India too has adopted radical economic policy measures to revitalise its economy. The Indian capital markets, which have attained a remarkably high degree of growth in the last decade, are on the brink for a further leap forward over the next ten years. With the opening of the economy to multinationals and the adoption of more liberal economic policies, the economy is driven more towards the free market economy.
Security markets are markets that deals in financial assets or instruments. These instruments are issued by business organisations, corporate units and central and state governments. They issue securities to mobilise financial resources for making investment and to meet current expenditure. As per the provisions of the Indian Companies Act both private and public companies can be incorporated. The private companies cannot transfer their shares freely and hence cannot offer their shares and securities to the public for trade. However all public companies are allowed to raise finance from the public through issue of their securities.
A security is an instrument of promissory note or a method of borrowing or lending or a source of contributing to the funds needed by a corporate body or non corporate body. As said earlier private corporate body are not allowed to market their securities to the public. Investment in capital market is made in the form of various instruments which are all claims of money. The Securities Contract Act, 1956 defines the security as inclusive of shares, scrips, stocks, bonds, debenture stock or any other marketable securities of a like nature in or of any debentures of a company or body corporate, the government and semi-government body etc.
The derivatives of securities and security index are also included in the meaning of securities. Thus, security is a type of transferable interest representing financial value. Traditionally, securities have been categorized into debt and equity securities, and between bearer and registered securities. They are often represented by a certificate. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, other derivatives and various other formal “investment instruments”. Currency notes, cheques, and some bills of exchange do not fall in this category.
Transferable interest in commodities like oil, food grains or metals can also be referred to as securities. One can enter into contracts to buy or sell various quantities of commodities in various commodity exchanges. These become transferable interest in the particular commodity. Stock market is also referred to as the Corporate Debt or Capital Market. While the money market, which deals with short-term financial needs of business and industry, is restricted to funds needed for a period of one year or less, instruments of the debt/capital markets are raised for medium or long term needs.
Indian Stock Market consists of three distinct segments: i. The Public Debt Market i. e. the market for Government securities, (also called Gilt-edged Market). These are interest bearing and dated securities. This market is regulated by RBI, the Central Bank and Banker to the Government. ii. PSU Bonds Market i. e. Bonds floated by public sector units, Nationalised banks and financial institutions for raising capital and also debentures floated by corporate. This is represented as the Corporate Debt Market. iii. The Equity Market for raising equity or preference share capital by all corporate.
Money invested in company shares is not refundable, but if the shares are listed in a stock exchange these can be sold or purchased, thus providing liquidity to such investments. Shares do not carry interest, but shareholders can participate in sharing the profits of the company declared by way of dividends, bonus shares etc. While the hope of receiving attractive dividends motivates the public to subscribe to the share capital, declaring dividend is not a legal obligation on the part of the companies, and hence not a right on the part of the shareholders.
At this context it is relevant to mention about two categories of stock market, i. e. * Primary Market covering new public issues of all categories of securities, including government securities, bonds and equity/preference capital. * Secondary Market, which deals with already issued securities of all types. Transactions of the secondary market are carried out through one of the authorised stock exchanges, where the traded security is listed. Primary Stock Market It is also called the market for public issues. This market refers to the raising of new capital (equity or debt i. . equity shares, preference shares or debentures) by corporate. Newly floated companies or existing companies may mobilise resource from the equity market by offering public issues. When equity shares are exclusively offered to the existing shareholders, it is called “Rights Issue”. When a company after incorporation initially approaches the public for the first time for subscription of its public issue it is called Initial Public Offer (IPO). Successful floating of a new issue requires careful planning, timing f the issue and comprehensive marketing efforts. The services of specialised institutions, like underwriters, merchant bankers and Registrars to the issue are available for the corporate body to handle this specialised job. Underwriters are financial institutions, which undertake to secure a committed quantum of equity or debt subscribed by the public, failing which they accept these shares or bonds as their own investment. The transactions relating to primary market are not carried out through stock exchanges.
However there is effective regulation of SEBI at every stage of a public issue. Secondary Stock Market The Secondary Market deals with the sale or purchase of already issued equity or debts by the corporate and others. The sale or purchases of these securities are carried out at the specific stock exchanges, where the companies get their public issues listed for trading. The main function of the secondary market is to provide liquidity to the listed securities by enabling a holder to easily convert the securities into cash through the stock exchanges.
An individual or an institution can either hold a portfolio of securities as a permanent investment, or he can hold a basket of securities for short periods and engage in buying and selling them to gain from market fluctuations. The secondary market also acts as an important indicator of the investment climate in the economy. When prices of existing securities are rising and there is large trading in the existing shares, such a boom in the secondary market correspondingly signifies that new issues, if floated at that point of time would be successfully subscribed.
LEGAL FRAMEWORK FOR SECURITIES MARKET
The securities market in India is strictly under the supervision of the Government. The government has enacted legislations, constituted bodies and most often publish rules to control the Indian securities market. Stock exchanges in India were continued to be regulated directly by the Government of India under powers conferred in terms of the Securities Contract (Regulations) Act 1956 up to the late Eighties.
In the year 1988 the Government of India constituted the Securities and Exchanges Board of India (popularly referred as ‘SEBI’) with Head office at Mumbai through an executive resolution to act as the independent regulator of stock exchanges, the primary market, mutual funds etc. The Capital Issues (Control) Act of 1947 was abolished in May 1992. The abolition of CCI (Controller of Capital Issues) and allowing free pricing of issues prompted many companies to raise funds from the equity market at a premium.
The ground was cleared for the incoming of a market regulatory authority replacing direct government control. SEBI was made into a statutory corporate body in the year 1992 with the passing of the Securities and Exchange Board of India Act on 30th January 1992. The objects clause of the Act explained the scope and purpose of the Act in these words: “An Act to provide for the establishment of a board to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto”.
Subsequently on 30th September 1994, the Government of India through a Gazette Notification delegated the powers conferred to it under the Securities Contracts (Regulation) Act 1956 to SEBI. The Government in the year 1996 also passed the Depositories Act 1996, which came into retrospective operation from 20 September 1995. SEBI is made the regulator for monitoring the due compliance and enforcing the provisions of this Act also. Two important Acts to govern Securities Transactions in India at present are: 1.
The Securities Contracts (Regulation) Act, 1956 2. The Securities and Exchange Board of India Act, 1992 The Securities Contracts (Regulation) Act, 1956 The Securities Contracts (Regulation) Act, 1956 containing a mere 31 sections, keeps a tight vigil over all the Stock Exchanges of India since 20th February 1957. The provisions of the Act were formerly administered by the Central Government. However, since the enactment of the Securities and Exchange Board of India Act, 1992, the SEBI has powers to administer almost all the provisions of the Act.
By virtue of the provisions of the Act, the business of dealing in securities cannot be carried out without a license from SEBI. Any stock exchange which is desirous of being recognized has to make an application under Section 3 of the Act to SEBI, who is empowered to grant recognition and prescribe conditions including that of having SEBI’s representation (maximum three persons) on the stock exchange and prohibiting the stock exchange from amending its rules without SEBI’s prior approval. This recognition can be withdrawn in the interest of the trade or public. The Securities and Exchange Board of India (SEBI)
Up to 1992, the capital primary market was controlled by the Controller of Capital Issue (CCI) formed under the Capital Issues Control Act. During that period, the pricing of capital issues was controlled by CCI. The premium on issue of equity shares issued through the primary markets was done in accordance with the Capital Issues Control Act. On April 12, 1988, the Securities and Exchange Board of India (SEBI) was constituted by the Government of India as a non-statutory body to promote the developments of the security markets and to provide adequate investor protection.
The CCI guidelines were abolished with the introduction of Securities and Exchange Board of India (SEBI) formed under the SEBI Act, 1992 with the prime objective of protecting the interests of investors in securities, promoting the development of, and regulating, the securities market and other related matters.
MAJOR REFORMS IN INDIAN SECURITY MARKET
Some of the major reforms undertaken since early 1990s to strengthen the security markets are:
- Control over issue of capital : A major initiative of liberalisation was the abolition of the Capital Issues (Control) Act, 1947 in May 1992. With this, government’s control over issue of capital, pricing of the issues, fixing of premium and rates of interest on debentures etc. ceased and the market was allowed to allocate resources to competing uses. In the interest of investors, SEBI issued Disclosure and Investor Protection (DIP) guidelines. The guidelines allow issuers, complying with the eligibility criteria, to issue securities at market determined rates. The market moved from merit based to disclosure based regulation.
- Establishment of regulator : A major initiative of regulation was establishment of a statutory autonomous agency, called SEBI, to provide reassurance that it is safe to undertake transactions in securities. It was empowered adequately and assigned the responsibility to (a) protect the interest of investors in securities, (b) promote the development of the securities market, and (c) regulate the securities market. Its regulatory jurisdiction extends over corporate in the issuance f capital and transfer of securities of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. All market intermediaries are registered and regulated by SEBI.
- Screen Based Trading : A major developmental initiative was a nation-wide on-line fully automated screen based trading system (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. SBTS electronically matches orders on a strict price/time priority and hence cut down on time, cost and risk of error, as well as on fraud resulting in improved operational efficiency. It allowed faster incorporation of price sensitive information into prevailing prices, thus increasing the informational efficiency of markets. It enabled market participants to see the full market on real-time, making the market transparent. It allowed a large number of participants, irrespective of their geographical locations, to trade with one another simultaneously, improving the depth and liquidity of the market. The SBTS shifted the trading platform from the trading hall of exchange to brokers’ premises. It was then shifted to the PCs in the residences of investors through the internet and to hand-held devices through WAP for convenience of mobile investors.
- Risk management : A number of measures were taken to manage the risks in the market so that the participants are safe and market integrity is protected.
- Trading Cycle : The trading cycle varied from 14 days for specified securities to 30 days for others and settlement took another fortnight. Often this cycle was not followed. This was often described as T+ anything. Many things could happen between entering into a trade and its performance providing incentives for either of the parties to go back on its promise. This had on several occasions led to defaults and risks in settlement. In order to reduce large open positions, the trading cycle was reduced over a period of time to a week initially. Rolling settlement on T+5 basis was introduced in phases. All scrips moved to rolling settlement from December 2001. T+5 gave way to T+3 from April 2002 and T+2 from April 2003. As per the latest amendment as on 1st April 2004, the rolling settlement has introduces at T+1 basis.
- Dematerialisation : Settlement system on Indian stock exchanges gave rise to settlement risk due to the time that elapsed before trades are settled. Trades were settled by physical movement of paper. This had two aspects. First, the settlement of trade in stock exchanges by delivery of shares by the seller and payment by the purchaser. The process of physically moving the securities from the seller to the ultimate buyer through the seller’s broker and buyer’s broker took time with the risk of delay somewhere along the chain.The second aspect related to transfer of shares in favour of the purchaser by the company. The system of transfer of ownership was grossly inefficient as every transfer involved physical movement of paper securities to the issuer for registration, with the change of ownership being evidenced by an endorsement on the security certificate. In many cases the process of transfer took much longer, and a significant proportion of transaction ended up as bad delivery due to faulty compliance of paper work.
- Theft, forgery, mutilation of certificates and other irregularities were rampant, and in addition the issuer had the right to refuse the transfer of a security. To prevent these problems, the Depositories Act, 1996 was passed to provide for the establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security by (a) making securities of public limited companies freely transferable subject to certain exceptions; (b) dematerialising the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form. . Derivatives : To assist market participants to manage risks better through hedging, speculation and arbitrage, SC(R) A was amended in 1995 to lift the ban on options in securities. The SC(R) A was amended further in December 1999 to expand the definition of securities to include derivatives so that the whole regulatory framework governing trading of securities could apply to trading of derivatives also. A three-decade old ban on forward trading, better known as BADLA, which had lost its relevance and was hindering introduction of derivatives trading, was withdrawn.Derivative trading took off in June 2000 on two exchanges.
- Settlement Guarantee : A variety of measures were taken to address the risk in the market. Clearing corporations emerged to assume counter party risk. Trade and settlement guarantee funds were set up to guarantee settlement of trades irrespective of default by brokers. These funds provide full risk coverage and work as central counter party. The Exchanges/ clearing corporations monitor the positions of the brokers on real time basis.
The market for trading securities is divided into primary market and secondary market.
Public limited companies initially sell their stock to the public through a process called an initial public offering. This is the primary market. However, buying and selling stock would be very difficult without a centralized system for buyers and sellers. Much of the securities are traded in the secondary market which is commonly known as stock market or stock exchange. A stock exchange is essentially a market place for stocks and bonds, with stock brokers earning small commissions on each transaction they make. Stocks that are handled by one or more stock exchanges are called listed stocks.
For a corporation’s stock to be listed on an exchange, the company must meet certain exchange requirements. Each exchange has its own criteria and standards, but in general a company must show that it has sufficient capital and is in sound financial condition. Once a company is listed, trading in its stock will be suspended if the company’s financial condition deteriorates to the point that it no longer meets the exchange’s minimum requirements. Thus, stock exchange is the place where the stocks, shares and other securities are bought and sold.
A stock exchange is a corporation of mutual organisations which provide the facilities for stock brokers to trade company stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities, as well as other financial instruments and capital events including the payment of income and dividends.
FUNCTIONS OF STOCK EXCHANGE
Indian stock exchanges operate under strict control and supervision of SEBI and Government, which help to make the stock exchange a key institution in the financial system and able to discharge its following functions. * Mobilisation of long term capital for companies
One of the important functions of stock exchange is that it translates short-term and medium-term investments into long term funds for companies. Most of the investors are interested in short-term to medium investments. The requirements of companies are long-term in nature, as they require equity capital on a more or less permanent basis and debenture capital for 7 to 10 years. Due to the attribute of negotiability and transferability of securities, through the stock market, it is possible for companies to obtain their long-term requirements from investors with short-term and medium-term horizons. Ensures safe and fair dealing A stock exchange works under a code for specified rules and regulations. Members of the stock exchange who deals in securities and listed companies are required to observe the code. Any dealer who does not follow the code will be expelled from the membership. The rules, by –law and regulations of stock exchanges which are approved by the government are meant to ensure that a reasonable measure of safety is provided to investors and transactions take place in competitive conditions which are fair to all concerned. Canalization of funds A stock exchange helps to canalise funds from unproductive to productive purposes. It enables long term investments to be financed by funds provided by individuals who invest it in the short term and medium term investments. Companies, which have more profitable investment opportunities, are normally able to raise substantial funds through the stock market, whereas companies, which do not have such opportunities, are normally not able to do so.
As a result, the stock market facilitates the direction of the flow of capital in the most profitable channels. * Raises standard of performance of companies When the equity capital of a company is listed on a stock exchange, the performance of the company is reflected in the market price of the equity stock, which is readily available for public information. In other words, the company’s performance is more ‘visible’ in the eyes of the public. Such a public exposure normally induces companies to raise their standard of performance. Provides information to investors A well regulated and efficient stock exchange performs the function of evaluation of securities. It publishes price quotations regularly. On the basis of this an investor can assess the worth of securities held by him. * A ready market for security trading Shares are traded on the stock exchanges enabling the investors to buy and sell securities. It provides a free, fair and continuous market for buying and selling securities. * Fixation of prices Prices of securities are determined by demand and supply factors.
Buyers and sellers behaviour in the market is clearly reflecting in their dealings. Traded prices are transparent and known to the public. Speculators equate demand and supply and thus smoothen the price movements in securities to a great extend. * Promotes economic growth It promotes economic development and industrial growth by encouraging investment in industries.
ROLE OF STOCK EXCHANGE IN THE ECONOMY
Stock exchanges have multiple roles in the economy, this may include the following:
Raising capital for businesses
The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public.
Mobilizing savings for investment
When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed, or kept in idle deposits with banks, are mobilized and redirected to promote business activity with benefits for several economic sectors such as agriculture, commerce and industry, resulting in a stronger economic growth and higher productivity levels. Facilitating company growth Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge against volatility, increase its market share, or acquire other necessary business assets. A takeover bid or a merger agreement through the stock exchange is one of the simplest and most common ways for a company to grow by acquisition or fusion.
Redistribution of wealth
Stocks exchanges do not exist to redistribute wealth although casual and professional stock investors through stock prices increases (that may result in capital gains for the Investor) and dividends get a chance to share in the wealth of profitable businesses.
By having a wide and varied scope of owners, companies generally tend to improve on their management standards and efficiency in order to satisfy the demands of these shareholders and the more stringent rules for public corporations imposed by public stock exchanges and the government.
Consequently, it is alleged that public companies (companies that are owned by shareholders who are members of the general public and trade shares on public exchanges) tend to have better management records than privately held companies (those companies where shares are not publicly traded, often owned by the company founders and/or their families and heirs, or otherwise by a small group of investors). However, some well-documented cases are known where it is alleged that there has been considerable slippage in corporate governance on the part of some public companies (pets. om (2000), Enron corporation (2001), One. tel (2001), Sunbeam (2001), Webvan (2001), Adelphia (2002), Mci world com (2002), or paramalat(2003), are among the most widely scrutinized by the media).
Creating investment opportunities for small investors
As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small stock investors because a person buys the number of shares they can afford.
Therefore the Stock Exchange provides the opportunity for small investors to own shares of the same companies as large investors.
Government capital-raising for development projects
Governments at various levels may decide to borrow money in order to finance infrastructure projects such as sewage and water treatment works or housing estates by selling another category of securities known as bonds. These bonds can be raised through the Stock Exchange whereby members of the public buy them, thus loaning money to the government.
The issuance of such municipal bonds can obviate the need to directly tax the citizens in order to finance development, although by securing such bonds with the full faith and credit of the government instead of with collateral, the result is that the Government must tax the citizens or otherwise raise additional funds to make any regular coupon payments and refund the principal when the bonds mature.
Barometer of the economy
Share prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth.
An economic recession, depression, or financial crisis could eventually lead to a stock market crash. Therefore the movement of share prices and in general of the stock indexes can be an indicator of the general trend in the economy.
STOCK MARKETS IN INDIA
The Indian securities market has become one of the most dynamic and efficient securities market in Asia today. The Indian market now conforms to international standards in terms of operating efficiency. In this context, it would be informative to understand the origin and growth of the Indian stock market.
During the latter half of the 19th century, shares of companies used to be floated in India occasionally. There were share brokers in Bombay joined together in 1875 to form an association called Native Share and Stockbrokers Association. The association drew up codes of conduct for brokerage business and mobilised private funds for investment in the corporate sector. It was this association which later became the Bombay Stock Exchange, which is the oldest stock exchange in Asia. Ahmedabad was a major centre of cotton textile industry. After 1880, many new cotton textile mills were started in and around Ahmedabad.
As new cotton textile enterprises were floated, the need for stock exchange at Ahmedabad was strongly felt. Accordingly in 1894, the brokers of Ahmedabad formed The Ahmedabad Share and Stockbrokers Association, which later became the Ahmedabad Stock Exchange, the second stock exchange of the country. During the 1900s Culcutta (Kolkata) became another major centre of share trading on account of the starting of several indigenous industrial enterprises. As a result, the third stock exchange of the country was started by the Culcutta stockbrokers at Culcutta (Kolkata) in 1908.
As industrial activity in the country gained momentum, existing enterprises in cotton textiles, woollen textiles, tea, sugar, paper, steel, engineering goods, etc. began to undertake expansion activities and new ventures were also floated. Yet another stock exchange was started in 1920 at Madras (Chennai). However, by 1923, it ceased to exist. Later, in 1937, the Madras Stock Exchange was revived as many new cotton textiles mills and plantation companies were floated in South India. Three more stock exchanges were established before independence, at Indore in Madhya Pradesh in 1930, at Hyderabad in 1943 and at Delhi in 1947.
Thus, at the time of independence, seven stock exchanges were functioning in the major cities of the country. Later, at present there are 23 stock exchanges functioning in India.
Trading Pattern of the Indian Stock Markets
Trading in Indian stock exchanges is limited to listed securities of public limited companies. They are broadly divided into two categories, namely, specified securities (forward list) and non-specified securities (cash list). Equity shares of dividend paying, growth-oriented companies with a paid-up capital of at least Rs. 50 million and a market capitalization of at least Rs. 00 million and having more than 20,000 shareholders are, normally, put in the specified group and the balance in non-specified group. Two types of transactions can be carried out on the Indian stock exchanges:- * (a) spot delivery transactions “for delivery and payment within the time or on the date stipulated when entering into the contract which shall not be more than 14 days following the date of the contract” : and * (b) Forward transactions “delivery and payment can be extended by further period of 14 days each so that the overall period does not exceed 90 days from the date of the contract”.
The latter is permitted only in the case of specified shares. The brokers who carry over the out standings pay carry over charges (cantango or backwardation) which are usually determined by the rates of interest prevailing. A member broker in an Indian stock exchange can act as an agent, buy and sell securities for his clients on a commission basis and also can act as a trader or dealer as a principal, buy and sell securities on his own account and risk, in contrast with the practice prevailing on New York and London Stock Exchanges, where a member can act as a jobber or a broker only.
The nature of trading on Indian Stock Exchanges are that of age old conventional style of face-to-face trading with bids and offers being made by open outcry. However, there is a great amount of effort to modernize the Indian stock exchanges in the very recent times. Over The Counter Exchange of India (OTCEI) The traditional trading mechanism prevailed in the Indian stock markets gave way to many functional inefficiencies, such as, absence of liquidity, lack of transparency, unduly long settlement periods and benami transactions, which affected the small investors to a great extent.
To provide improved services to investors, the country’s first ring less, scrip less, electronic stock exchange – OTCEI – was created in 1990 by country’s premier financial institutions – Unit Trust of India (UTI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), SBI Capital Markets, Industrial Finance Corporation of India (IFCI), General Insurance Corporation and its subsidiaries and Can Bank Financial Services.
The OTCEI allows listing of small and medium sized companies. The first issue listed on the OTCEI was in July 1992. The minimum issued share capital required of a company that wants to be listed on OTCEI is Rs. 3 million and the maximum Rs. 250 million. Listing on OTCEI is advantageous to companies because of the high liquidity of these securities, which is a result of compulsory market making, improved access and speed of transactions resulting from the extensive network of electronically interlinked counters.
Companies engaged in investment, leasing, finance, hire purchase, amusement parks etc. , and companies listed on any other recognized stock exchange in India are not eligible for listing on OTCEI. Also, listing is granted only if the issue is fully subscribed to by the public and sponsor. Trading at OTCEI is done over the centre’s spread across the country. Securities traded on the OTCEI are classified into:
- Listed Securities – The shares and debentures of the ompanies listed on the OTC can be bought or sold at any OTC counter all over the country and they should not be listed anywhere else
- Permitted Securities – Certain shares and debentures listed on other exchanges and units of mutual funds are allowed to be traded
- Initiated debentures – Any equity holding at least one lakh debentures of particular scrip can offer them for trading on the OTC. OTC has a unique feature of trading compared to other traditional exchanges. That is, certificates of listed securities and initiated debentures are not traded at OTC.
The original certificate will be safely with the custodian. But, a counter receipt is generated out at the counter which substitutes the share certificate and is used for all transactions. In the case of permitted securities, the system is similar to a traditional stock exchange. The difference is that the delivery and payment procedure will be completed within 14 days. Compared to the traditional Exchanges; OTC Exchange network has the following advantages:
- OTCEI has widely dispersed trading mechanism across the country which provides greater liquidity and lesser risk of intermediary charges. Greater transparency and accuracy of prices is obtained due to the screen-based scrip less trading.
- Since the exact price of the transaction is shown on the computer screen, the investor gets to know the exact price at which s/he is trading.
- Faster settlement and transfer process compared to other exchanges.
- In the case of an OTC issue (new issue), the allotment procedure is completed in a month and trading commences after a month of the issue closure, whereas it takes a longer period for the same with respect to other exchanges.
Thus, with the superior trading mechanism coupled with information transparency investors are gradually becoming aware of the manifold advantages of the OTCEI.
BOMBAY STOCK EXCHANGE LIMITED (BSE)
Bombay Stock Exchange Limited (BSE) is India’s important stock exchange. Among the stock exchanges in the country, Mumbai is the largest, with over 6000 stocks listed. The BSE accounts for over two third of the total trading volume in the country. Established in1875, the exchange is also the oldest in Asia. Approximately 70000 deals are executed on a daily basis, giving it one of the highest per hour rates of trading in the world.
There are around 3500 companies in the country which are listed and have a serious trading volume. The market capitalization of the BSE is Rs. 5 trillion. The BSE ‘Sensex’ is the widely used market index for the BSE.
NATIONAL STOCK EXCHANGE (NSE)
With the liberalisation of the Indian economy during the 1990s, it was inevitable that the Indian stock market trading system be raised to the level of international standards. The high powered committee on stock exchanges known as Pherwani Committee recommended, in 1991, the setting up of a new stock exchange as a model exchange and to function as a national stock exchange.
It was envisaged that the new exchange should be completely automated in terms of both trading and settlement procedures. On the basis of the recommendations of the Pherwani committee, a new stock exchange was promoted by the premier financial institutions of the country, namely IDBI, ICICI, IFCI, all insurance corporations, selected commercial banks and others. The new exchange was incorporated in 1992 as the National Stock Exchange (NSE). It started functioning in June 1994. S&P CNX Nifty is the widely used market index for NSE.
STOCK MARKET INDEX
Stock market indices are meant to capture the overall behaviour of equity markets. A stock market index is created by selecting a group of stocks that are capable of representing the whole market or a specified sector or segment of the market. The change in the prices of this basket of securities is measured with reference to a base period. There is usually a provision for giving proper weights to different stocks on the basis of their importance in the economy. A stock market index acts as the indicator of the performance of the overall economy or a sector of the economy.
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmark, to measure the performance of portfolios such as mutual funds Alternatively, an index may also be considered as an instrument (after all it can be traded) which derives its value from other instruments or indices. The index may be weighted to reflect the market capitalization of its components, or may be a simple index which merely represents the net change in the prices of the underlying instruments.
Simply, a stock market index (or just “index) is a number that measures the relative value of a group of stocks. As the stocks in this group change value, the index also changes value. If an index goes up by 1% then that means the total value of the securities which make up the index have gone up by 1% in value. 1. 2. 10 BSE SENSEX The BSE SENSEX, also called the BSE 30 or simply the SENSEX, is a free-float market capitalization-weighted stock market index of 30 well-established and financially sound companies listed on Bombay Stock Exchange.
The 30 component companies which are some of the largest and most actively traded stocks are representative of various industrial sectors of the Indian economy. Published since January 1, 1986, the SENSEX is regarded as the pulse of the domestic stock markets in India. The base value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79. On 25 July, 2001 BSE launched DOLLEX-30, a dollar-linked version of SENSEX. As of 21 April 2011, the market capitalisation of SENSEX was about 29,733 billion (US$ 593 billion) (42. 4% of market capitalization of BSE), while its free-float market capitalization was 15,690 billion (US$ 313 billion). 1. 2. 11 NSE S&P CNX NIFTY The S&P CNX Nifty, also called the Nifty 50 or simply the Nifty, is a stock market index, and one of several leading indices for large companies which are listed on National Stock Exchange of India, index based derivatives and index funds. Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL (IISL) is India’s first specialized company focused upon the index as a core product.
IISL has marketing and licensing agreement with Standard ;amp; Poor’s for co-branding equity indices. The S;amp;P CNX Nifty covers 22 sectors of the Indian economy and offers investment managers exposure to the Indian market in one portfolio. The S;amp;P CNX Nifty stock represents about 67% of the free float market capitalization of the stocks listed at National Stock Exchange (NSE) as on December 30, 2011. The S;amp;P CNX Nifty index is a free float market capitalisation weighted index. The index was initially calculated on full market capitalisation methodology. From June 26, 2009, the computation was changed to free float methodology.
The base period for the S;amp;P CNX Nifty index is November 3, 1995, which marked the completion of one year of operations of NSE’s Capital Market Segment. The base value of the index has been set at 1000, and a base capital of Rs 2. 06 trillion. The S;amp;P CNX Nifty Index was developed by Ajay Shah and Susan Thomas.
STATEMENT OF THE PROBLEM
As far as an investor is concerned, the unsystematic risk is not very important as it can be reduced or eliminated through diversification. It is an irrelevant risk. The risk that is relevant in investment decision-making is the systematic risk because it is undiversifiable.
Hence, the investor seeks to measure the systematic risk of a security. The systematic risk of a security is measured by a statistical measure called beta. While analysing beta coefficients or simply beta’s of different stocks, degree of reliability is an important factor that have to be considered.
OBJECTIVES OF THE STUDY
Primary Objective To study the beta estimation practice and its reliability in Indian Stock Markets with special reference to BSE. Secondary Objectives * To study the risk associated with stock market investments, giving preference to systematic risk. To measure the volatility of selected assets relative to the volatility of the market from BSE. * To examine whether the degree of reliability of beta coefficients for aggressive and defensive stocks are equal or not. 1. 6 RESEARCH METHODOLOGY Research methodology is a process to systematically solve the research problem. It may be understood as a science of studying how research is done scientifically. A research process consists of stages or steps that guide the project from its conception through the final analysis, recommendations and ultimate actions.
The research process provides a systematic, planned approach to the research project and ensures that all aspects of the research project are consistent with each other. Research studies evolve through a series of steps, each representing the answer to a key question. This includes specifications of research design, source of data, method of data collection and the sampling method. * RESEARCH DESIGN The research design used for the study is Analytical cum Empirical. Analytical researches are those researches in which the researcher use the facts or information already available, and analyze these to make a critical evaluation of the material.
On the other hand, empirical research relies on experience or observation alone, often without due regard for the system and theory. It is data-based research, coming up with conclusions which are capable of being verified by observation or experiment. In such a research, hypothesis or guess as to the probable results is must. * TYPE OF DATA The type of the data used for the study is secondary. This study uses the market index (Sensex) and the daily closing price of 30 scrips of BSE for the period of FY 2011-12 (1 Apr 2011- 31 Mar 2012). * SOURCES OF DATA
The study is based on secondary data, the required data for the study i. e. , the daily closing value of index Sensex and the daily closing values for the 30 scrips were available in BSE website. The data’s were collected from the websites of BSE (www. bse-india. com) and also from the website of yahoo finance (www. yahoofinance. com). * PERIOD OF THE STUDY The present study period was ranged between 01-04-2011 to 31-03-2012. During this period, there were 249 trading days in Bombay Stock Exchange (BSE) of India. Period for data collection and analysis for this particular research is 45 days. * SAMPLE DESIGN
The sample needed for the study is collected by using Non – random sampling method i. e. , the deliberate sampling; it involves the selection of particular units of the universe for constructing a sample which represent the universe. * SAMPLE SIZE The present analysing BSE Sensex thirty companies to estimate the systematic risk during the period of 1st April 2011 to 31st March 2012, for the purpose of this study, stocks listed in BSE Sensex were considered as sample and Sensex was considered as market index. BSE Sensex is a well diversified composite index with thirty most actively traded stocks.
So the sample size for the study consists of 30 companies listed in BSE Sensex. These 30 stocks represent 14 different industry types. The sample size for the study is shown as under in table depicts the number of stocks belonging to each industry type. TABLE-1. 2 List of Stocks in each industry type Sl. No| Industry| No. of stocks| Sl. No| Industry| No. of stocks| 1234567| AutomobileBankingConglomerateConsumer financeConsumer goodsElectricalIT| 5321113| 891011121314| Metals ;amp; MiningOil ;amp; gasPharmaceuticalsPowerReal estateSteelTelecommunication| 3322121|
Statistical Techniques used: The following statistical tools are used for the analysis, 1. Line chart 2. Scatter diagram 3. Standard deviation 4. Simple linear regression 5. Coefficient of correlation Standard Deviation In statistics and probability theory, standard deviation shows how much variation or “dispersion” exists from the average (mean, or expected value). A low standard deviation indicates that the data points tend to be very close to the mean, whereas high standard deviation indicates that the data points are spread out over a large range of values.
The standard deviation of a random variable, statistical population, data set, probability distribution is the square root of its variance. It is algebraically simpler though practically less robust than the average absolute deviation. A useful property of standard deviation is that, unlike variance, it is expressed in the same units as the data. In addition to expressing the variability of a population, standard deviation is commonly used to measure confidence in statistical conclusions.
Standard deviation is important in finance, where the standard deviation on the rate of return on an investment is a measure of the volatility of the investment. Standard deviation is most widely used measure of dispersion of a series and is commonly denoted by the symbol ‘? ’ (pronounced as sigma). Standard deviation is defined as the square-root of the average of squares of deviations, when such deviations for the values of individual items in a series are obtained from the arithmetic average. It is worked out as under: Standard deviation ? = ? (Xi-X’)2n
Where Xi = ith value of the variable X, X’ = Arithmetic average, n = Number of items Simple Linear Regression Regression is the determination of a statistical relationship between two or more variables. In simple linear regression, we have only two variables, one variable (defined as independent) is the cause of the behavior of another one (defined as dependent variable). Regression can only interpret what exists physically i. e. , there must be a physical way in which independent variable X can affect dependent variable Y. The basic relationship between X and Y is given by, Y = a + b X
This equation is known as the regression equation of Y on X (also represents the regression line of Y on X when drawn on a graph) which means that each unit change in X produces a change of b in Y, which is positive for direct and negative for inverse relationships. Thus, the regression analysis is a statistical method to deal with the formulation of mathematical model depicting relationship amongst variables which can be used for the purpose of prediction of the values of dependent variable, given the values of independent variable. Coefficient of correlation
Karl Pearson’s coefficient of correlation (or simple correlation) is most widely used method of measuring the degree of relationship between two variables. This coefficient assumes the following: 1) That there is linear relationship between the two variables; 2) That the two variables are casually related which means that one of the variables is independent and the other one is dependent; and 3) A large number of independent causes are operating in both variables so as to produce a normal distribution. Karl Pearson’s coefficient of correlation (r) =Nxy-x(y)[Nx2-x2][Ny2-y2] Where, N = number of pairs of scores ? xy = sum of the products of paired scores ?? x = sum of x scores ?? y = sum of y scores ?? x? = sum of squared x scores ?? y? = sum of squared y scores Karl Pearson’s coefficient of correlation is also known as the product moment correlation coefficient. The value of ‘r’ lies between ±1. Positive values of ‘r’ indicates positive correlation between the two variables (i. e. , changes in both variables take place in the statement direction), whereas negative values of ‘r’ indicate negative correlation i. e. changes in the two variables taking place in the opposite directions. A zero value of ‘r’ indicates that there is no association between the two variables. When r = (+)1, it indicates perfect positive correlation and when it is (-)1, it indicates perfect negative correlation, meaning thereby that variations in independent variable (X) explain 100% of the variations in the dependent variable (Y). We can also say that for a unit change in independent variable, if there happens to be a constant change in the dependent variable in the same direction, then correlation will be termed as perfect positive.
But if such change occurs in the opposite direction, the correlation will be termed as perfect negative. The value of ‘r’ nearer to +1 or -1 indicates high degree of correlation between the two variables. 1. 7 SCOPE OF THE STUDY * Through this study potential investors will get knowledge about the risks associated with stock market investments * The analysis is helpful for the common investors and researchers to get an idea about aggressive and defensive stocks * The research is based on 30 most actively traded stocks listed in BSE. * The study is much useful for the share broking firms The study looks into the degree of reliability of beta coefficients, which is a less explored area in this kind of studies 1. 8 LIMITATIONS OF THE STUDY * The study is micro in nature * Due to the time constraint, the study period is confined * The study is restricted to 30 stocks listed in BSE * An in-depth analysis on the cause of difference in degree of reliability beta coefficients is not being made * Number of statistical and technical tools used for the analysis are limited 2. 1 REVIEW OF LITERATURE Phillip R. Daves, Michael C. Ehrhardt and Robert A.
Kunkel (2000), in their study “Estimating systematic risk: The choice of return interval and estimation period”, analysed that, Financial managers can estimate the cost of equity via the CAPM approach. If the financial manager estimates the firm’s beta via regression analysis, then the financial manager must select both the return interval and the estimation period. Regarding return interval, this study finds that the financial manager should always select daily returns because daily returns result in the smallest standard error of beta or greatest precision of the beta estimate. However, regarding stimation period, the financial manager faces a dilemma. While a longer estimation period results in a tighter standard error for the estimate of beta, a longer estimation period also results in a higher likelihood that there will be a significant change in the beta. Thus, the beta estimated over longer estimation periods is more likely to be biased and of little use to the financial manager. The results show that an estimation period of three years captures most of the maximum reduction in the standard error of the estimated beta from a one-year estimation period to an eight-year estimation period.
Additionally, less than fifty percent of the firms experience a significant shift in beta over a three-year period. Dr Chris Tofallis (2005) in his study, “Investment volatility: A critique of standard beta estimation and a simple way forward”, analysed that OLS regression lines are not intended to represent an underlying relationship between two variables. Sadly, this misconception is one that is widespread. Rather, regression lines are intended for predicting the value of a dependent variable for a given value of an explanatory variable.
If we switch the variables in an OLS regression we produce a different line, and so we don’t have a unique relationship. This confusion between functional relationships and regressions can be traced back to Sharpe’s seminal 1964 paper. When speaking of a plot of the rate of return on an asset (Ri) versus the rate of return on an efficient ‘combination’ of assets (the market portfolio), he says (p. 438): “Part of the scatter of Ri is due to an underlying relationship with the return on the combination, shown by ? , the slope of the regression line”.
Haim Shalit and Shlomo Yitzhaki (2002), in their paper, “Estimating Beta”, presents evidence that Ordinary Least Squares estimators of beta coefficients of major firms and portfolios are highly sensitive to observations of extremes in market index returns. This sensitivity is rooted in the inconsistency of the quadratic loss function in financial theory. By introducing considerations of risk aversion into the estimation procedure using alternative estimators derived from Gini measures of variability one can overcome this lack of robustness and improve the reliability of the results.
John M. Hasty, Jr. and Bruce D. Fielitz (1974), in their research paper, “Systematic Risk for Heterogeneous Time Horizons”, says that, When the homogeneous time horizon method of analysis is applied to investment performance data for determining the rate of return and systematic risk surrogates of investments, systematic risk rankings vary dramatically according to the length of the differencing interval used in the analysis.
The implication of this conclusion is that many researchers undertaking investment performance analysis are faced with a dilemma. This dilemma is that of choosing between a realistic length investment time horizon as a differencing interval, and obtaining enough observations of rates of return to obtain statistically significant results. If the total time period of interest is relatively short, the need for a statistically significant number of observations will probably dictate the length of the differencing interval used.
However, the findings of this study indicate that such a procedure will not apply to all investors because their time horizons probably differ from that assumed by the differencing interval. Thus, systematic risk surrogates will be incorrectly specified for most investors. The traditional homogeneous time horizon model is appropriate only for that small subset of investors, whose time horizon happens to correspond exactly to the differencing interval assumed in the return calculations.
The heterogeneous time horizon model developed in this paper may be used without explicitly assuming any particular length investment time horizon. The rate of return characteristic and the systematic risk surrogates determined with the heterogeneous time horizon model can be used with data observations separated by various length time intervals without limiting the applicability of the results obtained to investors whose time horizons happen to correspond to the time interval used between observations.
Michelle L. Barnes and Anthony W. Hughes (2000), in their paper named, “Conditional Beta Estimation and Forecasting with Panel Data Methods”, analysed that, Standard procedures for the estimation and testing of conditional CAPM models with time-varying or random beta typically do not exploit the panel nature of financial data sets. Using a model based on Ferson and Harvey’s (1999) extension of the FF model to allow for ime-varying alpha and beta, they showed that the null hypothesis of homogeneity restrictions on the time-varying alpha and beta are generally not rejected, and that model selection criteria select models with homogeneity restrictions imposed upon the model parameters, and random beta versions of the same. They also demonstrated that zero randomness in beta can be rejected in favour of homogeneous or heterogeneous randomness, and that homogeneous randomness in beta is rejected in favour of heterogeneous randomness.
Since it is legitimate in a statistical sense to impose such homogeneity restrictions on the conditional variables, they illustrate that estimating and testing the conditional CAPM version of the FF model employing panel methods yields many benefits. First of all, the power of conditional CAPM tests are improved with the imposition of homogeneity constraints.
They substantiated this with an example where in the last subsample of data, the weak form of the conditional CAPM test could not be rejected on average against heterogenous time-variation in alpha, while the homogenous time-varying alpha alternative forced a strong rejection of CAPM for this subperiod. For forecasting beta, models with homogeneous time-variation in the intercept or alpha or beta perform well relative to the FF or FH models, especially for forecasting the beta on the HML and SMB factors.
Modelling homogeneous time-variation in beta tends to yield better results than the more extreme assumptions of zero or heterogeneous time-variation in beta. Additional homogeneity in alpha is helpful for forecasting beta on the SMB and HML factors. For middle and high portfolios, the fully-heterogeneous model performs poorly for all three factors.
Finally, the panel framework provides a better understanding of the role of conditional variables and multi-factors, more precise estimates of beta relative to the FH-type fully-heterogenous models, and coefficient values that are qualitatively different to other standard pooled approaches to estimating beta. Attila Odabasi (2003), in his paper, “Some Estimation Issues on Betas: A Preliminary Investigation on the Istanbul Stock Exchange”, reports the findings of a preliminary investigation on beta stability on the Istanbul Stock Exchange for the January 1992 – December 1999.
The study investigates the stability of beta across time, the effect of return interval and diversification on beta estimates with the use of a sample of 100 stocks. The beta stability is empirically inspected for individual stocks and portfolios of different sizes. The adequate beta estimation period seems to be dependent on the return interval. The analysis of portfolios implies that diversification and beta stability are positively correlated. The assessment of next-period beta becomes reliable for portfolios with ten or more stocks.
Lastly, based on the actual estimates of portfolio betas, he observe that beta estimates tend to regress towards the mean. The conversion was stronger for the portfolios with extreme beta estimates. This paper reports an ad hoc investigation on the effects of estimation period, return interval, and diversification on beta stability on the Turkish stock market. The examination of the numerical portfolio betas implies that beta estimates tend to regress towards the mean.
The conversion is stronger for the portfolios with extreme beta estimates. Angela Ryu (2011), in her paper, “Beta Estimation Using High Frequency Data”, analysed, using high frequency stock price data in estimating financial measures often causes serious distortion. It is due to the existence of the market microstructure noise, the lag of the observed price to the underlying value due to market friction. The adverse effect of the noise can be avoided by choosing an appropriate sampling frequency.
In this study, using mean square error as the measure of accuracy in beta estimation, the optimal pair of sampling frequency and the trailing window was empirically found to be as short as 1 minute and 1 week, respectively. This surprising result may be due to the low market noise resulting from its high liquidity and the econometric properties of the errors-in-variables model. Moreover, the realized beta obtained from the optimal pair outperformed the constant beta from the CAPM when overnight returns were excluded. The comparison further strengthens the argument that the underlying beta is time-varying.
John Y. Campbell and Tuomo Vuolteenaho (2002), in the paper, “Bad Beta, Good Beta”, explains the size and value “anomalies” in stock returns using an economically motivated two-beta model. We break the CAPM beta of a stock with the market portfolio into two components, one reflecting news about the market’s future cash flows and one reflecting news about the market’s discount rates. Inter temporal asset pricing theory suggests that the former should have a higher price of risk; thus beta, like cholesterol, comes in “bad” and “good” varieties.
Empirically, they found that value stocks and small stocks have considerably higher cash-flow betas than growth stocks and large stocks, and this can explain their higher average returns. The model also explains why the sort on past CAPM betas induces a strong spread in average returns during the pre-1963 sample but little spread during the post-1963 sample. Finally, the model achieves these successes with the discount-rate premium constrained to the prediction of the inter temporal model. The model has important implications for rational investors.
Aswath Damodaran, in his paper “Estimating Risk Parameters” analysed that, the conventional estimate of this relative risk, measured by regressing stock returns against a market index, is flawed for three reasons – the market index can be dominated by a few stocks, the beta estimate can be noisy and the firm itself might have changed during the course of the regression. While these regression betas can be modified to reflect financial fundamentals and there exist measures of relative risk that do not require a regression, the bottom-up approach has the most promise when it comes to delivering updated betas for most firms.
In the bottom-up approach the beta for a firm is estimated as the weighted average of the unlevered betas of the different businesses that the firm operates in, adjusted to reflect both the current operating and financial leverage of the firm. Thierry Post, Pim Van Vliet and Simon Lansdorp (2010), in their study “Sorting Out Downside Beta”, investigates the role of downside risk for the cross-section of US stock returns. The M-SV equilibrium forwards the SV beta as the relevant measure of systematic downside risk for individual stocks.
This beta generally differs systematically from two commonly employed alternative measures of systematic downside risk: the asymmetric response model (ARM) beta of Harlow and Rao (1989) and the downside covariance (DC) beta used by Ang, Chen and Xing (2006). In contrast to the SV beta, these two alternative measures generally are not consistent with the first principles of choice theory. Their conclusions are robust to the inclusion of co-variates and changes in the sample period. Correcting for firm-level size, value, momentum, reversal, idiosyncratic volatility, o-skewness and illiquidity does not change our conclusions. Interestingly, sampling error introduces a negative correlation between SV-beta estimates and firm-level momentum and reversal variables, and correcting for this correlation increases the estimated downside risk premium. SV beta dominates the other betas also in each of three historical subsamples and mostly so in the earliest and most recent years. In summary, their results suggest that downside risk, when properly defined and estimated, is a driving force behind stock prices.
Risk aversion thus not only helps to explain why stocks yield higher average returns than safer asset classes, but also why high-risk stocks yield higher average returns than low-risk stocks, ceteris paribus. 3. 1 INDUSTRY PROFILE 3. 1. 1 DEPOSITORIES Shares are traditionally held in physical or paper form. The method has its own inherent weaknesses, including loss and theft of certificates, forged or fake certificates, cumbersome and time-consuming procedures for the transfer of shares, etc. To eliminate these weaknesses, a new system called depository system has been established.
The system holds shares in the form of electronic accounts in the same way a bank holds our money in a savings account. The depository system offers paperless trading and transfer of shares through modern technology. It enables processing of share trading and transfers electronically without involving share certificates and transfer deeds, thus eliminating the paper work involved in scrip-based trading and share transfer system. A depository is an organisation like a Central Bank, i. e. Reserve Bank where the securities of an investor are held in the electronic form.
Thus a depository is an organisation where the securities of a shareholder are held in the electronic form at the request of the shareholder through the medium of a Depository Participant. In India, there are two depositories viz. 1. National Securities Depository Limited (NSDL) 2. Central Depository Services India Limited (CDSL) National Securities Depository Ltd (NSDL) was the first Indian depository; promoted by the Industrial Development Bank of India, the Unit Trust of India and the National Stock Exchange to provide electronic depository facilities for securities traded in the equity and the debt market.
Central Depository Services India Ltd (CDSL) is the other Indian Depository; promoted by the Stock Exchange, Mumbai in association with Bank of India, Bank of Baroda, State Bank of India and HDFC Bank. Functions In 1996, the Indian government passed the Depositories Act allowing the establishment of securities depositories in India. The principal function of a depository in the Indian context is to dematerialise securities and enable their transaction in book-entry form. In simple terms, the depository provides the following functions: 1) Dematerialisation
It is the process of converting securities in physical form into holdings in book-entry form. 2) Rematerialisation It is the process of converting securities in electronic form into holdings in physical form, for those investors who opt to move out of the depository system. 3) Account transfer The securities are transferred by debiting the transferor’s depository account and crediting the transferee’s depository account. 4) Pledge and hypothecation Depositories allow the securities placed with them to be used as collateral to secure loans and other credits.
The securities pledged or hypothecated are transferred to a segregated or collateral account through book entries in the records of the depository. 5) Linkages with the clearing system The clearing system performs the functions of ascertaining the pay-in (sell) or payout (buy) of brokers who have traded in the stock exchange. Actual delivery of securities to the clearing system from the selling brokers, and delivery of securities to the buying broker is done electronically by the depository.
To achieve this, the depositories and clearing system are electronically linked. 6) Corporate actions The depository may handle corporate actions in two ways. In the first case, it merely provides information to the issuer about the persons entitled to receive corporate benefits. In the other case, depository itself takes the responsibility of distribution of corporate benefits. 3. 1. 2 DEPOSITORY PARTICIPANTS The operations in the Depository System involve the participation of a Depository, Depository Participants, Company/Registrars and Investors.
The company is also called the Issuer. A Depository Participant is the agent of the Depository and is the medium through which shares are held in the electronic form. They are also the representatives of the investor, providing the link between the investor and the company through the Depository. Similar to the brokers who trade on investor’s behalf in and outside the Stock Exchange; a Depository Participant (DP) is the representative in the depository system providing the link between the company and investor through the depository.
The Depository Participant will maintain securities account balances and intimate to the investor the status of holding from time to time. According to SEBI guidelines, Financial Institutions like banks, custodians, stock brokers etc. can become participants in the depository. A DP is one with whom we need to open an account to deal in electronic form. While the Depository can be compared to a bank, DP is like a branch of a bank with which we can have an account. The Depository Participants are the link between the shareholder, the company and the depository.
Banks, Financial Institutions, Custodians, Stock Brokers etc. can become DPs subject to their meeting certain requirements prescribed by the Depositories and SEBI. Activities of a DP include, * Maintaining the securities account balances * Intimation of the position of the account to investors periodically An investor can open his account with one or more DPs as he likes. The procedure for opening an account with the Depository Participant is similar to opening a Savings Bank Account with the bank.
After having opened the account, an investor can hold shares of any number of companies in his account, provided all such companies have entered the depository system. After an account is opened with the DP an investor can buy or sell shares in electronic form without share certificates or transfer forms, provided the seller or buyer also holds shares in electronic form. An investor can sell the shares in the depository mode through any share broker. All one needs to do is to provide one’s details of one’s account with the DP, with a delivery instruction to debit one’s share account with the number of shares sold by him.
When one buys shares in the depository mode one must similarly, inform the broker about one’s depository account details so that the shares bought would be credited to one’s account with the DP. Here again just like a Bank, the Depository Participant will give us a Pass Book or a Statement of Holdings. The Statement of Holdings will be despatched periodically by the Depository Participant; however the Statement of Holdings can be sent to us as and when requested for a fee. In case of any discrepancy in the Statement of Holdings, we can contact our Depository Participant.
If the discrepancy cannot be solved at the Depository Participants level, we should approach the Depository concerned for clarification. There are absolutely no restrictions on the number of DPs one can open accounts with. Opening an account with a DP is very similar to opening a bank account. Just as one can have savings or current accounts with more than one bank, one can open accounts with more than one Depository Participant. However, it is necessary to open accounts in the same sequence of names in which the shares are held by investor. Every transaction in his account will be authorised by investor.
He can authorise any transaction either by affixing his signature or by using any smart card similar to the use of an ATM or a credit card. The Depository Participant will advertise its facilities and we should go through them carefully. There is a facility by which we can lock our account so that the Depository Participant will not be able to carry out any transactions in our absence without authorisation. Operation of Depository System The Depository System functions very much like the banking system. A bank holds funds in accounts whereas a Depository holds securities in accounts for its clients.
A Bank transfers funds between accounts whereas a Depository transfers securities between accounts. In both the systems, the transfer of funds or securities happens without the actual handling of funds or securities. Both the Banks and the Depository are accountable for the safe keeping of funds and securities respectively. The company signs an Agreement with the depositories and installs the necessary hardware and software for operations. When we decide to have our shares in electronic form, we should approach a Depository Participant (DP), an agent of the depository, and open an account.
We should surrender our share certificates in physical form, and DP will arrange to get them sent to and verified by the company and, on confirmation, credit our account with an equivalent number of shares. This process is known as dematerialisation. Share transactions (such as the sale or purchase, transfer or transmission) in the electronic form can be effected in a much simpler and faster way. All we need to do is that after confirmation of sales or purchase transaction by our broker, we should approach our DP with a request to debit or credit our account for the transaction.
The depository will immediately arrange to complete the transaction by updating our account. There is no need for separate communication to the company to register the transfer. With the depositories in place, there is a need to ensure that an effective online trading mechanism is available for the retail investors to transact in the paperless form. Effectively all leading stock exchanges including Mumbai Stock Exchange and National Stock Exchange have moved towards online trading. Further the National Stock Exchange established a view to provide an efficient and transparent securities market to the investors.
When we buy shares already in the depository mode, we will become the owner of those shares in the depository within a day of the settlement being completed. There is no need to apply to the company for registering the shares in our name. Thus, there will be no possibility of loss or theft when the share certificates are posted to the company. DP sends a statement of account on a quarterly basis wherein all the holdings of the shareholder for the current period is listed out. In the event of any transactions during the quarter, a fortnightly updates of those transactions is also sent to the shareholder.
When any corporate event such as rights or bonus or dividend is announced for a particular security, the Depositories will give all the details of the clients having electronic holdings of that security as of record date or book closure to the Registrars and Transfer Agents of the company, who will then calculate the corporate benefits due to all the share holders. The disbursement of cash benefits such as dividend or interest will be done by the company whereas the distribution of securities or entitlements will be done by the
Depositories based on the information provided by the Registrars and Transfer Agents of the company. Thus, bonus or right shares, if any, will be credited to our account electronically. Advantages of Depository System A depository system provides the following advantages to an investor: a) Shares cannot be lost or stolen or mutilated. b) There is no need to doubt the genuineness of shares, that is, whether they are forged or fake. c) Share transactions, such as transfer, transmission, and so on, can be effected immediately. ) Transaction costs are usually lower than that in the physical segment. e) There is no risk of bad delivery. f) Bonus or rights shares allotted to you will be immediately credited to your account. g) Investor will receive the statement of account of transactions/holdings periodically. Industry and players The trading on stock exchanges in India used to take place through open outcry without use of information technology for immediate matching or recording of trades. This was time consuming and inefficient. This imposed limits on trading volumes and efficiency.
In order to provide efficiency, liquidity and transparency, NSE introduced a nation-wide on-line fully-automated Screen Based Trading System (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. SBTS electronically matches orders on a strict price/time priority and hence cuts down on time, cost and risk of error, as well as on fraud resulting in improved operational efficiency.
It allows faster incorporation of price sensitive information into prevailing prices, thus increasing the informational efficiency of markets. It enables market participants, irrespective of their geographical locations, to trade with one another simultaneously, improving the depth and liquidity of the market. It provides full anonymity by accepting orders, big or small, from members without revealing their identity, thus providing equal access to everybody. It also provides a perfect audit trail, which helps to resolve disputes by logging in the trade execution process in entirety.
This sucked liquidity from other exchanges and in the very first year of its operation, NSE became the leading stock exchange in the country, impacting the fortunes of other exchanges and forcing them to adopt SBTS also. Today India can boast that almost 100% trading take place through electronic order matching. Technology was used to carry the trading platform from the trading hall of stock exchanges to the premises of brokers. NSE carried the trading platform further to the PCs at the residence of investors through the Internet and to handheld devices through WAP for convenience of mobile investors.
This made a huge difference in terms of equal access to investors in a geographically vast country like India. NSE has main computer which is connected through Very Small Aperture Terminal (VSAT) installed at its office. The main computer runs on a fault tolerant STRATUS mainframe computer at the Exchange. Brokers have terminals installed at their premises which are connected through VSATs/leased lines/modems. An investor informs a broker to place an order on his behalf. The broker enters the order through his PC, which runs under Windows NT and sends signal to the Satellite via VSAT/leased line/modem.
Indian stock market marks to be one of the oldest stock market in Asia. It dates back to the close of 18th century when the East India Company used to transact loan securities. In the 1830s, trading on corporate stocks and shares in Bank and Cotton presses took place in Bombay. Though the trading was broad but the brokers were hardly half dozen during 1840and 1850. In 1860, the exchange flourished with 60 brokers. In fact the ‘Share Mania’ in India began with the American Civil War broke and the cotton supply from the US to Europe stopped. Further, the brokers increased to 250.
At the end of the war in 1874, the market found a place in a street (now called Dalal Street). In 1887, “Native Share and Stock Brokers’ Association” was established. In 1895, the exchange acquired a premise in the street, which was inaugurated in 1899. The financials and investment industry is a highly competitive in nature with almost well established firms diversifying and entering into this industry. As of today there are Over 2000 brokers, 10000 sub brokers and 1 Crore investors. It is highly competitive with entry of new aggressive players.
Retail broking is highly fragmented industry with falling brokerages Value added services and online trading, the new fad. 3. 2 COMPANY PROFILE Northeast Broking Services Ltd, founded in 1995, is one of the largest Investment companies based in Andhra Pradesh, with 75 Professionals, 150 support staff and extensive network in Andhra Pradesh, Gujarat, Karnataka, Kerala, Maharashtra, Tamilnadu and rapidly entering into all over India. Northeast is a premier broking, trading and clearing member of BSE CASH AND F&O, NSE CASH AND F&O and HSE and as well as the two leading commodity exchanges in the country NCDEX and MCX.
And it is also registered as a Depository Participant (DP) with NSDL and CDSL. With more than 15 years in this particular business; Northeast is known for its financial strength and stability, superior customer service, and continued operation excellence. Northeast Broking Services Limited (NBSL) has been in the business of stock broking, dealing in shares and derivatives for the past 17 years. It has got a chain of service centres operating from various locations in Andhra Pradesh. The Coimbatore branch started in 2005. 3. 2. 1 Mission & Vision
Our aim is to provide you with a reliable, secure, fast and most importantly cost effective stock broking and DEMAT services to enable you to gain better returns on your investment. We wish to work together with you to maximize your assets and secure your future. 3. 2. 2 Products and Services * Stock Broking: Northeast offers trading in equities in NSE and BSE cash market segment. Northeast provides offline facilities like excellent trading atmosphere, individual terminal and instant execution and confirmation. * Derivatives Broking: Northeast provides facility to trade in futures and options in NSE F&O and BSE F&O market.
Our efficient risk management takes adequate care and precaution in monitoring the margin positions of the clients. * Commodities Broking: You can buy and sell commodities in both the leading MCX and NCDEX commodity exchanges through our subsidiary Northeast commodities private limited. * Mutual Funds: Northeast offers a wealth of mutual fund choices along with the competitive advice to help you invest wisely. * Depository Services: Northeast as a Depository participant of NSDL and CDSL offers effective demat services at all times, with economic fee structure for Individuals, traders and sub-brokers. IPO’S: Northeast enables you to invest prudently in the prospective and lucrative public issues. Our research team would guide you to choose appropriate IPO that suit your objective. * Internet Trading: A new value added product from Northeast designed for Traders and Investors enabling to operate from any location, by using the state of art of internet trading by logging on to www. northeastltd. com. * Research and Advisory Service: Northeast has well qualified and experienced research team, who would constantly keep informing the Investors with wise investment decisions.
The information would be provided free of cost to clients. 3. 2. 3 Customised Services provided to the client * SMS Alert security on daily Trading. * Electronic contract note through E- Mail Daily. * Phone confirmation on daily trading. * Monthly account status reports to the client through post. * Credit facility up to 5 Days for delivery trading. * Daily exposure of client credit amount in to 5 times for intraday trading. * Immediate payout fund transfer through CMS. * Personalized client services. 4. 1 RISK Investment planning is almost impossible without a thorough understanding of risk.
Generally, a lot of nervousness brings to investors because of the instability of the capital market. Risk is commonly viewed as the instability associated with fluctuations in a portfolio’s value – that is, the movement of the markets and the implications on portfolio performance. Most investors fear that market instability leads portfolio values down. However, risk must be examined not only by looking at portfolio volatility but also by assessing systematic and unsystematic risk, inflation risk, return sensitivity, time and portfolio allocation adjustments.
The standard assumption is that investors are rational. Rational investors prefer certainty to uncertainty. It is easy to say that investors dislike risk, but more precisely, we should say that investors are risk averse. A risk-averse investor is one who will not assume risk simply for its own sake and will not incur any given level of risk unless there is an expectation of adequate compensation for having done so. In fact, investors cannot reasonably expect to earn larger returns without assuming larger risks. Investors deal with risk by choosing the amount of risk they are willing to incur.
Some investors choose to incur high levels of risk with the expectation of high levels of return. Other investors are unwilling to assume much risk, and they should not expect to earn large returns. Risk is the quantifiable likelihood of loss or less-than-expected returns. Risk includes the possibility of losing some or all of the original investment. Risk is usually measured using the historical returns or average returns for a specific investment. Uncertainty about the future benefits to be realised from an investment. Thus, risk can be defined as the measurable possibility of loss on an investment.
There is risk involved if the outcome of an investment is uncertain at the time the investment is made. Although the outcome is uncertain, it is measurable. Risk and return are the primary ingredients in making investment choices. Expected return must be compared to risk. As risk increases, so must the return to compensate for the greater uncertainty. This is called the risk-return trade-off; namely, that there is greater risk in investment classes that offer potential of higher returns and vice-versa. Therefore, an investor has to choose between higher returns with higher risk versus lower risk accompanied by but may offer higher return.
On the other hand, government securities have minimum risk, so a low return is enough. Risk (uncertainty) creates potential higher return. We should seek the highest possible return at the risk level we are willing to accept. As an investor, we need to evaluate each investment separately, comparing expected returns with the risks. The trade-off is also a warning flag: Higher potential returns flag higher risks, even if the risks are not apparent at first. In general, the risk-return characteristics of each of the major investment instruments can be displayed in a risk-return graph, as shown in figure given above.
Although the locations on the diagram are only approximate, it should be clear that we can pick from a wide variety of vehicles, each having certain risk-return combinations. 4. 1. 1 TYPES OF INVESTMENT RISKS Modern investment analysis classifies the traditional sources of risk causing variability in returns into two general types: those that are pervasive in nature, such as market risk or interest rate risk, and those that are specific to a particular security issue, such as business or financial risk. Therefore, while considering total risk these two categories have to be taken in to account.
Thus risk is divided into systematic risk and non-systematic risk. The general market component of risk is called systematic risk and a specific (issuer) component of the risk is called unsystematic risk. Thus; Total risk = Systematic risk + Unsystematic risk 4. 1. 1. 1 SYSTEMATIC RISK Occurrence of certain events can affect all companies firms at the same time. This is known as systematic risk. Events such as inflation, war and fluctuating interest rates influence the entire economy and not just a specific firm or industry.
Diversification cannot eliminate this type of risk. Therefore, it is considered un-diversifiable risk. This type of risk accounts for most of the risk in a well-diversified portfolio. Systematic risk relates to volatility due to a particular market or economy. Systematic risk originates from uncontrollable forces and is therefore not unique to the stock of a company. It affects all stocks in the market. Virtually all securities have some systematic risk, whether bonds or stocks, because systematic risk directly encompasses interest rate, market, and inflation risks.
The investor cannot escape this part of the risk because no matter how well he diversifies, the risk of the overall market cannot be avoided. If the stock market declines sharply, most stocks will be adversely affected; if it rises strongly, most stocks will appreciate in value. These movements occur regardless of what any single investor does. Clearly, market risk is critical to all investors. Systematic risk comes from perils that affect the entire economy. Within an asset class, this risk cannot be reduced by diversification.
For instance, macroeconomic factors like monsoon failure can have an adverse effect on equity, as an asset class, and the consequent impact on a highly diversified market index. In total, the total risk of each stock is irrelevant. It is the systematic component of that total instability that is relevant for valuation. It is the only element of total risk that investors will get paid to assume, and it is measured by beta. Beta aids in estimating how much the security will rise or fall if you know which direction the market will go. It assists in determining risk and expected return.
Types of Systematic Risks Systematic risk is further subdivided into the following. 1. Market Risk The variability in a security’s returns resulting from fluctuations in the aggregate market is known as market risk. All securities are exposed to market risk including recessions, wars, structural changes in the economy, tax law changes, even changes in consumer preferences. Market risk is sometimes used synonymously with systematic risk. Market risk occurs due to the reaction of investors in the stock market. The trend in the market may be either upward or downward.
The upward trend is known as bullish trend and downward trend is known as bearish trend. Due to these there will be variability in the return of investments. Both tangible and intangible events affect stock market. Political, social or economic or natural hazards are real and tangible events. On the other hand, intangible events are related to market psychology. The market psychology is affected by the real events. But reactions to the tangible events become over reactions and they push the market in a particular direction. A series of reaction occur based on hearsay and all investors try to sell their holdings. . Interest Rate Risk The variability in a security’s return resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes generally affect securities inversely; that is, other things being equal, security prices move inversely to interest rates. As the interest rate goes up, the market prices of fixed income securities falls. Those who are holding the bonds with lesser coupon rates feel their bonds market value has come down. The reason for this movement is tied up with the valuation of securities.
Conversely, if interest rate declines, the bond price increases. Interest rate risk affects bonds more directly than common stocks and is a major risk faced by all bondholders. As interest rates change, bond prices change in the opposite direction. 3. Purchasing Power Risk A factor affecting all securities is purchasing power risk also known as inflation risk. It is arising from decline in purchasing power on account of inflation. There is the chance that the purchasing power of invested amount will decline. With uncertain inflation, the real return involves risk even if the nominal return is safe (e. . , a treasury bond). This risk is related to interest rate risk, since interest rates generally rise as inflation increases, because lenders demand additional inflation premiums to compensate for the loss of purchasing power. 4. Regulation Risk Some investments can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. The risk of a regulatory change that could adversely affect the stature of an investment is a real danger. 4. 1. 1. 2 UNSYSTEMATIC OR DIVERSIFIABLE RISK
Unsystematic risk (also called diversifiable risk) is risk that is specific to a company. This type of risk could include dramatic events such as a strike, a natural disaster like fire or something as simple as falling sales. Two common sources of unsystematic risk are business risk and financial risk. Diversification can help eliminate unsystematic risk from a portfolio. It is unlikely that events such as the ones listed above would happen in every firm at the same time. Therefore, by diversifying, one can reduce their risk. There is no reward for taking on unnecessary unsystematic risk.
Thus it is clear that unsystematic risk is unique to a company or industry and can be sharply reduced by diversification. For instance, presence of pharma and FMCG stocks in the portfolio will help to offset the high volatility inherent in IT and media stocks. Such risks are specific to the company and are reduced by diversification. Unsystematic risk relates to volatility due to a particular security. Examples are union problems and financial difficulties of the firm. When additional securities are added to the portfolio, we spread the risk and the unsystematic risk of the portfolio decreases.
Types of Unsystematic Risks a) Business Risk The risk of doing business in a particular industry or environment is called business risk. For example, as one of the largest steel producers, Tata Steel faces unique problems. Similarly, General Motors faces unique problems as a result of such developments as the global oil situation and Japanese imports. b) Reinvestment Risk The YTM (Yield To Maturity) calculation assumes that the investor reinvests all coupons received from a bond at a rate equal to the computed YTM on that bond, thereby earning interest on interest over the life of the bond at the computed YTM rate.
In effect, this calculation assumes that the reinvestment rate is the yield to maturity. If the investor spends the coupons, or reinvests them at a rate different from the assumed reinvestment rate of 10 percent, the realized yield that will actually be earned at the termination of the investment in the bond will differ from the promised YTM. And, in fact, coupons almost always will be reinvested at rates higher or lower than the computed YTM, resulting in a realized yield that differs from the promised yield. This gives rise to reinvestment rate risk. c) International Risk
International Risk can include both Country risk and Exchange Rate risk Exchange Rate Risk: All investors who invest internationally in today’s increasingly global investment arena face the prospect of uncertainty in the returns after they convert the foreign gains back to their own currency. Therefore, investors today must recognise and understand exchange rate risk, which can be defined as the variability in returns on securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk. Country Risk: Country risk, also referred to as political risk, is an important risk for investors today.
With more investors investing internationally, both directly and indirectly, the political, and therefore economic, stability and viability of a country’s economy need to be considered. d) Liquidity Risk Liquidity risk is the risk associated with the particular secondary market in which a security trades. An investment that can be bought or sold quickly and without significant price concession is considered liquid. The more uncertainty about the time elements and the price concession, the greater the liquidity risk. A Treasury bill has little or no liquidity risk, whereas a small OTC stock may have substantial liquidity risk. . 2 MEASUREMENT OF SYSTEMATIC RISK The systematic risk causes variability in returns due to changes in the economy or the market. Such changes may affect all securities in the market in a greater or lesser degree. Hence an investor cannot avoid such risks by diversification of securities in the portfolio. On the other hand, diversification of investments helps an investor to reduce unsystematic risk. Instead of investing in a single stock, it is possible to have a diversified portfolio consisting of stocks and bonds of different companies from different industries.
Unsystematic risks can be avoided by diversifying among different industries rather than just investing the same one. They may also be effectively mitigated by diversifying across different assets classes such as stocks, bonds, mutual funds, real estate holdings, etc. The portfolio design is very important to minimise the risk effectively. Diversification can help to reduce portfolio risk by eliminating unsystematic risk for which investors are not rewarded. Investors are rewarded for taking market risk. Therefore it is highly necessary to understand how systematic risk is measured.
The Meaning of Beta
The systematic risk of a security is measured by statistical measure called beta. The data required for the calculation of beta are the historical data of returns of the individual security and the returns of a representative stock market index. A share’s beta factor is the measure of its volatility in terms of market risk. The beta factor of the market as a whole is 1. 0. Market risk makes market returns volatile and the beta factor is simply a yardstick against which the risk of other investments can be measured. Risk or uncertainty describes a situation where here is not first one possible outcome but array of potential returns. Risk is measured as the beta factor or ?. Thus the beta indicates the sensitivity of the return on shares with the return on the market. Some companies’ activities are more sensitive to changes in the market. The beta value of 1. 0 is the benchmark against which all shares’ betas are measured. The interpretation of beta goes as follows. * Beta > 1 – Aggressive shares These shares tend to go up faster than the market in a rising (bull) market and fall more than the market in a declining (bear) market. * Beta < 1 – Defensive shares
These shares will generally experience smaller than average gains in a rising market and smaller than average falls in a declining market. * Beta = 1 – Neutral shares These shares are expected to follow the market. The beta value of a share is normally between 0 and 2. 5. A risk-free investment (a treasury bill) has a ? = 0 (no risk). The most risky shares like some of the more questionable share investments would have a beta value closer to 2. 5. Measurement of Beta The systematic risk of an investment is measured by the covariance of an investment’s return with the returns of the market.
Once the systematic risk of an investment is calculated, it is then divided by the market risk, to calculate a relative measure of systematic risk. This relative measure of risk is called the ‘beta’ and is usually represented by the symbol ?. If an investment has twice as much systematic risk as the market, it would have a beta of two. Two statistical methods may be used for the calculation of beta, namely the correlation method or the regression method. Using the correlation method, beta can be calculated from the historical data of returns by the following formula: ? =rim? i? m? m2
Where rim= Correlation coefficient between the returns of stock i and the returns of the market index m. ?i= Standard deviation of returns of stock i. ?m= Standard deviation of returns of the market index. ?m2= Variance of the market returns. The second method of calculating beta is by using the regression method. The regression model postulates a linear relationship between a dependent variable and an independent variable. The model helps to calculate the values of two constants, namely ? and ?. ? measures the change in the dependent variable in response to unit change in the independent variable, while ? easures the value of the dependent variable even when the independent variable has zero value. The form of the regression equation is as follows.